CEO Overconfidence and the Speed of Adjustment of Cash Holdings
Firms hold cash for several reasons, e.g., to seize strategic opportunities as they arise or as abuffer against unexpected shocks. While research has focused on the question as to how much cash a firm should hold, it has mostly ignored how quickly firms move back to their optimal or target cash holdings level once they have been pushed away from that level.
The corporate finance literature argues that there exists an optimal cash holdings level for each firm, i.e., a level which maximizes the firm’s value. Previous studies suggest that firms have cash holdings levels close to their optimal level. In other words, when firms deviate from their optimal level or when the optimal level changes, they move to their optimal level virtually instantaneously. However, there are several factors that reduce the speed at which firms move towards their optimal cash holdings level. Such factors include macroeconomic shocks, financial constraints and agency conflicts between managers and shareholders. Existing research has studied the impact of these factors while typically assuming that managers and investors share the same set of beliefs. Under this assumption, both managers and investors agree about what constitutes the optimal cash holdings level. However, if the set of beliefs differs (e.g., due to managerial behavioural biases), the CEO may have a different view on what constitutes the optimal cash holdings level. In this study, we focus on how CEO overconfidence, a behavioural bias, affects the speed of adjustment of cash holdings and firm value.
We argue that overconfident CEOs, defined as those CEOs that hold exercisable options that are deep in the money, slow down the speed of adjustment towards what the market considers to be the optimal cash level. On the one hand, this is because overconfident CEOs may perceive the cost of future external financing to be relatively expensive. Hence, they hold higher levels of cash compared to other CEOs to finance future investments. On the other hand, overconfident CEOs may perceive their firm’s equity to be underpriced and hence expect the cost of future external financing to decline. As a result, they hold lower levels of cash now as they rely more heavily on internal cash to finance current investments and delay raising external financing. Whatever the impact of CEO overconfidence on the firm’s cash holdings level, the above suggests that overconfident CEOs are likely to slow down the speed of adjustment towards the optimal cash holdings level.
To test our hypothesis, we use a sample of 1,913 non-financial listed US firms during the period between 1992 and 2017. What do we find? First, we find that the speed of adjustment is slower for firms with overconfident CEOs. It takes about seven months longer for firms with such CEOs to adjust their cash holdings level relative to the remaining firms. Second, we find that if the actual cash holdings level exceeds its optimal level, i.e., there is a cash surplus, firms with overconfident managers have a greater adjustment speed. This suggests that overconfident CEOs are likely to overinvest when cash is plentiful. Finally, we find that both CEO overconfidence and the speed of adjustment of cash holdings are value relevant. Put together, our results suggest that firms with a high speed of adjustment and a non-overconfident CEO have the highest value whereas firms with a low speed of adjustment and an overconfident CEO have the lowest value.
Overall, our study highlights the importance of CEO overconfidence for the speed of adjustment of cash holdings. Our results have important implications for investors as the firm’s speed of adjustment of cash holdings and CEO overconfidence are value relevant.
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